Until 2000, the trading of options was conducted on physical trading floors using an open outcry method. In response to increasing competition as equity options classes became listed on multiple exchanges, the options marketplace has now become highly automated. While some exchanges retain their trading floors, others are completely electronic and floorless. One model employed by option exchanges is a hybrid trading system model. In a hybrid model, the exchange has a physical trading floor, but also has an electronic order execution facility. A typical hybrid trading system model supports one or more limit order books where guaranteed, electronic matching takes place for small size customer orders. Orders not qualifying for fully-electronic execution, such as large orders and complex orders, are generally routed to workstations on the trading floor for execution or facilitation by a specialist or equivalent market maker. The specialist or equivalent market maker typically presents an order to the trading crowd for possible electronic and open outcry price improvement before executing it or sending it to another exchange at the NBBO.
A second trading model employed on option exchanges is generally referred to as a competing market maker model. In this model, typically used by fully-electronic exchanges without a physical trading floor, market makers in each option class compete against a primary or lead market maker for incoming orders. The market makers are electronically notified when an incoming order is eligible for price improvement, and interested participants send their price-matching and/or price-improving orders remotely during a brief (e.g., 1- to 3-second) auction period.
In these order execution models, incoming orders are typically divided among all the market makers willing to trade at a certain price, with the largest percentage of incoming orders allocated to the market makers who quote the largest size or who trade the most often. Thus, market makers often take the contra side of an incoming order to encourage trading. Also, in models that support price-improvement auctions, a market maker can step ahead of displayed orders and quotes by as little as a penny to participate with specific incoming orders. This encourages the exchanges to momentarily improve their prices only in response to specific incoming orders, rather than tightening the NBBO spread.
Accordingly, there is a need for an “order-driven” options trading system that utilizes price/time priority principles, rather than being “quote-driven,” so that all orders and quotes compete equally, while still providing an incentive for market makers to make a market in each specific option class. There is also a need that such a system only allows a market maker to receive a guaranteed entitlement if it is already quoting at the national best bid and offer (“NBBO”) when an incoming order is received. In such a system, the market maker would not be allowed to improve its price (either by changing its quote or by sending a superior-priced order) for the purpose of executing against a specific incoming order. Such an options trading system would reward market makers for narrowing the spread, promote more competition between orders and quotes and, as a result, encourage users of the system, i.e., both members and non-members alike, to compete against each other.